We still think that most people won’t really be interested in LIZ until it’s a $10 stock. The opacity of the model is lifting, and the value is there. Get in while you can.
One of the knocks on LIZ, and reasons for its underperformance, has been strategic inaction at the management and board level – those days are gone. In addition to posting positive top-line trends and its first revenue growth in 5-years back when sales were twice what they are today, LIZ provided much welcomed clarity around some of its recent strategic initiatives. With the addition of greater visibility, as well as positive fundamental improvement across each of its brands, the catalysts are in place to drive shares substantially higher over the immediate-term TRADE (3-weeks or less) and intermediate-term TREND (3-months or more).
Management acknowledged that it does indeed have “several irons in the fire”, confirming a recent article that it’s shopping its MEXX business. The senior leadership team is also pursuing other potential asset sales with the intention to de-lever and substantially ‘de-risk’ the company by year end. While a sale is one of the near-term catalysts, a deal can only be considered speculation until it’s made public. So let’s focus on the facts:
1) The company added both sizing and timing around its actions to reduce Mexx’s underperforming store base and regardless of a potential sale, it’s much bigger than expected. The plan is to close 1/3 of Mexx stores (all in Europe) by the end of the first half of FY12 with 70 by the end of January and another 35-40 by the end of the first half of next year. This could amount to a $60mm reduction in operating losses according to our math (see below).
2) Another incremental change in the quarter was an additional $25mm in cost savings expected in FY12 from the sale of the last company-owned DC facility. Combined, we expect these steps to reduce SG&A margin by at least 500bps next year in addition to increasing confidence in the company’s ability to achieve EBITDA of $200-$220mm in 2012.
3) For the first time in over 3-years, every direct brand comped positively with Juicy, Lucky and Mexx all comping significantly better than expected. Perhaps most noteworthy, were the results out of Mexx with comps coming in at +3.6% and fall wholesale orders up 11%. The results reflect continued momentum in the turnaround of the company’s biggest variable business - which is now under way (accounting for roughly 1/3 of total revs and generating $90mm in operating losses each of the last two years). We’re the first to admit that when something comps down for long enough, it’s eventually going to hit rock bottom. But this is positive for LIZ nonetheless.
Juicy was probably the next biggest surprise with comps coming in flat, but is still expected to comp down slightly in 2H with the new product coming through later than expected. A significant reduction in inventories (down 9%) impacted margins in the quarter, but will be key to driving improved profitability in 2H. At Lucky, a rebound in the women’s business and strong denim sales, which account for ~60% of revenues, accelerated the top-line. Kate Spade, to put it simply, is crushing it. We expect continued strength in these two brands throughout the back half.
4) Due to Q2 results and incremental cost savings initiatives underway, the company reaffirmed its prior 2011 and 2012 outlook. The only change was in the confidence with which management spoke to Mexx’s profitability, shifting from a ‘hope/goal’ of EBITDA breakeven to stating that it would be breakeven “at a minimum” by 2012. In addition, it was suggested that Mexx could in fact post a positive operating profit next year (ironic statement just as it prepares for a sale), which is what we have modeled given the changes underway. Regardless of the company’s wordsmithing of what it hopes, prays, or expects EBITDA to be – we are still confidently modeling $235mm.
5) It’s impossible to ignore leverage, given our sense that it is the #1, 2 and 3 most relevant factors for investors when analyzing LIZ. In fact, debt increased this quarter to $769mm up from $716mm in Q1 due to the increase in Eurobond debt as a result of the foreign currency exchange as well as CapEx and restructuring. While we expect debt to increase further in Q3 due to higher working capital requirements, we should see a substantial reduction by year-end. In fact, the company expects debt at year-end to be below 2010 year-end levels ($578mm). In an effort to mitigate this overhang, the company is clearly looking to sell an asset (or two) that would accelerate de-levering the company and be a materially positive catalyst for shares. It is important to remember that this is not a capital intensive business, it is a working capital intensive business. When LIZ jettison’s Mexx, the removal of working capital drag will be disproportionately large relative to the parent company.
Bottom-line, with greater visibility and improving fundamental performance, we expect multiple expansion and greater interest in the name to drive shares higher from current levels. Shares are currently trading at 5.8x our 2012 EV/EBITDA estimates. Assuming a 6.5-7x multiple suggests 25% to 40% upside from here and an $8 to $9.50 stock.
We recognize that stocks don’t trade on sum-of-parts…but the reality is that the opacity of this model has been so intense for the past four years that most investors literally haven’t known what they’ve been buying. Now that the core Liz brand is stable and growing, the sourcing office is shuttered, retail stores are closed, Mexx is on the block, and DC is on its way out the door, people will see what they’re getting to a much greater extent.
We have included our current 2011 SOTP (which takes into account current debt of $768mm) as well as what 2012 could look like assuming $500mm in debt and modest multiple expansion across key brands. Keep in mind that the DKNY license rolls off at year-end in 2012 (it’s operating at a slight loss) and Mexx will most likely no longer be in the portfolio accounting for ~$1.50 in value from this analysis. That still leaves you with over $15 in value and significant upside from here. As bullish as we have been recently on LIZ, we are incrementally more bullish on the near to intermediate term outlook for the company.
Mexx Store Consolidation Analysis:
Here’s our Mexx store consolidation analysis and the impact it could have on the company and Mexx business. At Mexx Europe you’re looking at close to a 60/40 retail/wholesale split. Based on the assumption that 70 stores close by year end and another 35-40 in 1H 2012 with stores up to 10-12k sq. ft. (we used a 9k avg.) at an average sales productivity of $200 per sq. ft., we are looking at a $190mm hit to revenue on a base of ~$315mm. With consolidated Mexx sales productivity of ~$250 per sq. ft. (including Canadian retail), we discounted these stores at 80% of an underperforming European store base. The key takeaway here is the removal of ~$60mm in operating losses associated with these stores.